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Good deflation and good inflation

A couple of weeks ago, Scott Sumner pointed out that many conservative-leaning economists think that certain types of deflation can be good. The same economists, though, are typically reluctant to acknowledge that by a similar argument, certain types of inflation can be good.

As Sumner points out, there are economists who understand that the argument is symmetrical. He mentions George Selgin. Selgin’s 1997 monograph Less Than Zero: The Case for a Falling Price Level in a Growing Economy implies in its title that in a shrinking economy there may be a case for a rising price level. Selgin in fact discusses the case for such "good inflation" on page 39 of the monograph, although his main focus is on "good deflation" because at the time he wrote, it was a more unusual idea. Selgin, and fellow blogger on this site Steve Horwitz, make remarks in Sumner’s comment section.

Selgin stated his arguments in a way to give them textbook simplicity for ease of understanding. In an actual free banking system, the details of the system might add some wrinkles that would require changes to the  form is arguments while preserving their spirit. Expectations about the supply of the monetary base and thus the path of prices over time might differ considerably depending on whether the monetary standard was gold, silver, a frozen fiat monetary base, a commodity basket, or something else. Under some standards, inflation and deflation might be relative to average expectations for the price level rather than absolute. It remains an open question to me whether a standard in which the monetary base was shrinking and expected to continue shrinking (as was the case in some earlier eras with the supplies of gold, silver, and copper) would be compatible with the monetary system attaining the "full information" ideal of not being a disturbing factor to trade.

  • Paul Marks

    First Happy New Year everyone. Now….

    The confusion between money and real wealth was one of the main fallacies that the classical political economists refuted.

    If an economy is "shrinking" then something is wrong (perhaps government spending and taxes have been increased, or perhaps there has been an outbreak of demented regulations), the point is to find what is wrong and correct it (to roll back whatever interventions are causing the problem), NOT to produce money money (inflate the money supply) and then think one has achieved something.

    Of course it is not true that any amount of money is optimal – for example if an evil wizard waved his magic wand and got rid of all the gold in the world, bar one grain, this one grain of gold would NOT be suitable as a major currency. However, in reality the limited amount of gold (or silver or…..) is not a problem – as prices falling gradually over time (as better ways to produce goods and services are developled) is not a problem – indeed it is a GOOD thing. There is, of course, a vast difference between prices falling gradually over time (because better ways of producing goods and services have been developed) and a sudden crash in prices – because a credit money bubble has burst.

    Inflation (i.e. an increase in the money supply) is never "good" apart from in an extreme situation (as with the above example of the evil wizard making all the gold vanish bar one grain – a good wizard comming along and waving his magic wand to "inflate" the gold supply back again, would be a good thing).

    Certainly if by "inflation" one does not mean an increase in the money supply, but means "prices rising in the shops" (over time – NOT as a one off event due to the removal of price controls or whatever) that is never a good thing. Even an inflation that does not lead to prices rising in the shops can be incredibly damaging (for example the Ben Strong inflation of the late 1920s – which led directly to the crash of 1929, or the repeated Greenspan inflations of the 1990s and 2000s that have led to the present financial crises), if prices are actually going up in the shops (year after year) then the inflation has become vast and open (in short vast damage has already been done to the capital structure – asset prices, malinvestments must be widespread and the economy is in real trouble).

    On the final two points – a frozen fiat monetary base and a commodity basket.

    A frozen fiat monetary base (Milton Friedman position in his last years) is no good if there is still vast expanding "broad money" (i.e. bank credit) as there will still be a "boom/bust" event (which is INEVITABLE with vast expanding bank credit over and above real savings) and the POLITICAL pressure to bail out the banks (and the general economy) by expanding the monetary base will be too great.

    The "old" Chicago School (1930s – pre Milton Friedman) understood much (if not all) of the above – but I am not sure that Milton Friedman ever did (even in his last years). This is why the old Chicago School was deeply hostile to lending being greater than real savings (i.e. the expansion of bank credit – "broad money").

    On the "commodity basket" idea (F.A. Hayek).

    Hayek in his early and middle years understood that such a commodity "index" is simply a tool of theorectical examination of economics – it can not be used in the "real world" to create a currency (due to the very nature of such an "index" – such indexes can not be used for "real world" stuff, they are theorectical and historical tools only). However, in his late years Hayek appears to have forgotten this and started to think of such an index (indeed indexes generally) as "real" things.

    Be that as it may, George Selgin has himself pointed out (on this very site) that such an "index" or "commodity basket" money would be "nonconvertable" – in short a CON TRICK. One would go to the issuer of the notes to claim one's "basket of commodities" (of the agreed percentages of gold, silver, copper……) only to be told "did you not understand – these notes are not convertable".

    In short the whole thing is a scam, a fraud (in fact – if not in positive law).

    • Notes promising a commodity basket are as convertible as notes promising a single commodity. For example, WalMart could issue notes promising a standard basket of groceries, so many gallons of milk of standard quality (WalMart brand), so many pounds of flour and so on. You would exchanges these notes for the standard basket at WalMart. Such notes are a far more natural tool for common consumers subjectively evaluating prices.

      How much gold is an iPod worth to me? I don't have a clue really, and the question is practically meaningless outside of a market offering many different goods all priced relative to gold. How many fiat dollars is an iPod worth? This question is even less meaningful.

      How many life sustaining meals is an iPod worth? This question also requires market prices signaling relative scarcity, but the question appeals much more to my intuition regardless of other prices.

    • Of course, you would also exchange your WalMart Standard Grocery Basket notes for anything else you want at WalMart or anywhere else accepting the notes. WalMart ensures that it has sufficient inventory to satisfy demand for the Standard Grocery Basket, as opposed to everything else people demand for the notes. WalMart routinely performs this service already.

      No one demands redemption of these notes simply to hoard the standard groceries, because many of the groceries are perishable and have limited shelf life or require costly storage like refrigeration. Hoarding these goods is necessarily more costly than retrieving them as needed from WalMart's continually revolving inventory. A run on the standard is possible in theory, but if this run occurs, people fear starvation, so a systemic failure of the monetary system is the least of your worries.

      On the other hand, gold is extremely hoardable. It is one of the most hoardable goods imaginable, because it is highly scarce and durable and typically has an inelastic supply. Gold is also extremely dense (has a small volume per unit of market value), so storage cost is relatively low. People holding gold in a deflationary context have good reason to continue holding it and to increase their holdings, and under a gold standard, increased holding of gold is itself deflationary, so a feedback seems inevitable.

      Without a monopoly, a gold standard poses no fundamental problem, because demand for credit leveraging gold falls as gold becomes too dear. People then prefer to promise other standards when accepting credit. This changing preference has no effect only if creditors are all powerful in the market for credit, only if consumers of credit have no choice.

      That's the standard argument against a statutory gold standard effectively establishing a monopoly for gold as a standard of value when extending credit by making it an exclusive legal tender. What's wrong with it?

      Of course, we had a bimetallic standard in the U.S. before 1873, when the Federal government ceased coining silver money altogether and thus effectively established (or began the process of establishing) gold as an exclusive legal tender, despite the fact that much more common silver is the historical dollar standard. The original "dollars" in the colonies were silver coins minted in Spain, and the first U.S. coinage act set the par value of gold as its market value in terms of these silver coins at the time, not the other way around.

      If the fixed gold/silver exchange rate was the problem, Congress could have stopped coining gold and let the gold price float, effectively making silver the exclusive legal tender rather than gold. Why didn't it? This question has answers, but "the market" is not a credible answer. Creditors preferred gold, but creditors are not the credit market.

  • I don't much accept Selgin's case for deflation, but he makes the case for a falling price level in the context of rising productivity, rather than a growing economy per se. An economy can grow when the volume of productive factors grows while factor productivity does not grow. Selgin's case for a falling price level does not apply to this sort of growth, and any similar case for a rising price level applies only to falling productivity, not to a falling volume of productive factors.

    This point needs emphasis, because we're approaching a sustained period of historically low rates of labor force growth, even a declining labor force (though not so much in the U.S.), accompanied by growing demands for consumption by a burgeoning class of retirees and would-be retirees. The declining labor force itself does not imply any virtuous inflation, by (Schuler's interpretation of) Selgin's reckoning, without a corresponding fall in productivity.

    If the U.S. experiences declining productivity coincident with a declining volume of productive factors while retirees demand more consumption, inflation seems likely, but it doesn't seem a healthy sort of inflation.

    If retirees are simply entitled to more consumption by forcible redistribution (through statutory pensions with COLAs for example), nominal prices might not rise, but the disposable income of remaining producers could fall, diminishing their capacity to increase their productivity by investing in themselves. This investment is particularly crucial if other "investment" is largely illusory, as when the retirees purchase entitlement to rents imposed on the producers, Treasury securities being only the most obvious example.

    If the Federal government uses the "investment" of Treasury purchasers to pay 100,000 college students to obtain psychology degrees every year, while the entire U.S. economy employs only 100,000 of these similarly qualified professionals, this "investment" purchases very little produce for the "investors" to consume. Hear Alex Tabarrok on the latest EconTalk for example.

    Of course, much "investment" is actually consumption on credit perversely renamed, and so is much (most) of the expenditure financed by Treasury sales, including the endless expenditure on war. Paying for a stream of future income is not what I call "investment" unless the payments purchase resources producing the income by satisfying consumers in a free market. How much nominal "investment" in the U.S. actually fits this description? I don't have a clue, but I do know that much "investment" does not fit the description.

  • nickik

    I think 'good inflation' is the wrong way to put it. 'Non artefical rise of the pricelevel' would be the right way to put it. This can happen even in a free market, typical examples are scarcity of natural resources (atm almost every aspect of the economy is touched by the price for oil), natural desaster (earthquake shutting down a hole countrie).

    When there is a rise of the pricelevel smart people should look closly if there is a politicel issue, if not we just have to exept it with a gruge. With deflation we expect it with a smile.